Jun 14, 2017 – from Investor Insights

Are Ultra-Long Treasuries the Next Big Thing?

The U.S. Treasury Department rarely lets market conditions dictate its policy deci­sions. But a growing body of experts, including the new Treasury Secretary, argue that now is the time to deviate from this strategy by implementing an “ultra-long” bond. On the sell side, ultra-long bonds would allow the federal government to lock in low interest rates and finance massive infrastructure projects at ankle-high hurdle rates. On the buy side, these debt instruments would enable institutional investors to match their long-term liabilities with long-term assets. Despite concerns about soft demand, ultra-long U.S. bonds may soon become a reality.

While the United States doesn’t currently issue bonds with maturity dates longer than 30 years, the new administration may be trying to change that. The Treasury Depart­ment in April asked primary bond dealers to assess the potential demand, pricing, and market for 40-, 50-, and 100-year bonds. More recently, department officials said that Treasury Secretary Steven Mnuchin had set up an internal working group to further investigate the possibility.

The easiest argument in favor of ultra-long bonds is an extension of the argument for selling more of the 10- and 30-year bonds we already issue—namely, that long-term rates are now so low that we can get a super deal for U.S. taxpayers by locking them in. Consider first that the current 10-year Treasury yield is 2.15 percent. Then consider that the average 10-year yield over the entire history of the United States (since 1790) has been around 5 percent. Since 1900, the aver­age has been 4.9 percent. Looking ahead, the CBO currently expects it to go back up to 3.6 percent by 2028 and 4.1 percent by 2035.

So from this perspective, borrow­ing heavily at today’s low rates—and locking them in for as long as possible—seems like a no brainer. Extending the weighted average maturity (WAM) of U.S. debt, currently at less than six years, would safeguard taxpayers. Mnuchin himself said shortly after the election that, “We’ll look at potentially extending the maturity of the debt, because eventu­ally we are going to have higher interest rates, and that’s something that this country is going to need to deal with.”

Assuming long-term rates will rise is, as traders would say, a directional bet. But there may be another, less-risky argument in favor of ultra-longs. By locking in the interest cost on a sig­nificant share of the federal debt, the Treasury could insure the stability of interest outlays even in the event of a future crisis that sends short-term rates soaring. This insurance could itself “de-risk” the national debt and bring down long-term rates. And yes, the possibility of fiscal crisis may yet spook the market. We should keep in mind another CBO projection: By 2047, U.S. public-held debt is expected to grow six-fold, rising to 150 percent of GDP. This rise is driven only by population aging—and does not include any tax-cut magic figured in by GOP House leaders or by OMB director Mick Mulvaney.

Still another argument in favor of ultra-longs derives from an old axiom of financial theory: You can always maximize efficiency and minimize cost by matching the duration of assets and liabilities. On the public side, the federal government doesn’t currently have many tangible assets with a known duration. But it is considering investing a lot in such assets in the near future. American voters favor a Marshall-plan size effort to repair and expand America’s infrastructure, and the three most popular presidential candidates in 2016—Trump above all—emphatically agreed.

Bottom line: A low-yielding 100-year Treasury bond might be an ideal way to fund a 100-year bridge or harbor. And Trump suggests there are about $1 trillion of such bridges and harbors. Economic advisor Gary Cohn himself acknowledged that low interest rates provide an “enormous opportunity” to fund infrastructure using long-term bonds (though his comments don’t square with the administration’s plan to fund infrastructure through tax incentives).

On the private side, there is an even larger demand for long-term duration matching. Many institutional investors, especially life insurers and pension plans, have a fiduciary responsibility to match their large 40- and 50-year liabilities with equivalent assets. Problem: Where to find a risk-free 40- or 50-year asset? Solution: The U.S. Treasury creates one. The need is especially acute today when so many firms are terminating their defined-benefit plans and trying to “de-risk” their remaining liabilities (sometimes by paying an insurance company to take them over). But without a risk-free ultra-long, there’s always out-year interest-rate risk. Many private investors would pay a premium to shed that risk.

To be sure, ultra-long bonds pose risks. The most obvious is that issuing more long-term debt would push up the long end of the yield curve. And that gives many economists pause. After all, if it was quantitative easing that pulled us out of recession, do we really want to reverse the flow and engage in “quantitative tightening”? The second-biggest topic discussed at the Federal Reserve these days (right behind the timing of hiking the fed funds rate) is how and when the Fed will begin offloading its balance sheet back to the public. Is there truly enough demand out there for new long and ultra-long debt instru­ments such that the U.S. Treasury could sizably reduce its interest-rate risk—without burdening the global economy with higher long-term rates? Organizations from Credit Suisse to the Treasury Borrowing Advisory Committee say no, there probably isn’t.

In any case, the United States is not alone in exploring the benefits of ultra-longs. We are in fact late to the party. Nations that have started issuing a 50-year bond in recent years include Canada (with a 3.0 percent yield), Italy (2.9 percent), Britain (2.6 percent), and France (1.9 percent). Meanwhile, Mexico (4.2 percent), Ireland (2.4 percent), and Belgium (2.3 percent) have issued 100-year bonds. Thanks to their ultra-long efforts, British sovereign debt WAM stands at a whopping 14.9 years. Britain (and India) have a history of issuing bonds (known as “perpetuals” or “consols”) that have no maturity date at all—i.e., infinite-maturity bonds. (Britain recently redeemed the consols that financed the Napoleonic Wars.) Clearly these countries have concluded that ultra-longs are worth it.

History teaches that governments turn to longer-term debt instruments not just when interest rates are currently low, but also when they face massive upcoming liabilities. When prospects are sunnier, they tend to shed their longer-term debt. In fact, one of the reasons why the U.S. Treasury discontinued the 30-year bond back in 2002 (it was restart­ed in 2006) was because policymakers didn’t see any big liabilities on the horizon. (They must have missed the massive Boomer cohorts bearing down on them.) Given the demographic reality now upon us—of slower growth and rising benefit costs—the discus­sion of ultra-longs is certainly timely. While we’re not facing the Napoleonic Wars, we may be facing the fiscal equivalent thereof.

Takeaways

  • Realize that ultra-long bonds have more upside than downside. The rollout of ultra-long bonds would enable the U.S. government to lock in low interest rates, “de-risk” the national debt from sudden interest-rate surges, and help us fund massive infrastructure projects. While most investors stand to lose from ultra-long bonds in the event of rising interest rates, life insurers and company pensions would value the ability to match their long-term liabilities with long-term assets. With Boom­ers promising to further strain a federal budget already overburdened by entitlements, ultra-long bonds is one tool to help get us through the next few decades.
  • Anticipate a 50-year bond to come first. Though much of Wall Street remains skeptical of ultra-long bonds, the tailwinds pushing them forward may be irresistible. If they do come to fruition, which duration is the most likely? Government officials may be hesitant to introduce a 40-year bond that could easily cannibalize demand for 30-year Treasuries, which constitutes the current gold standard for long-term debt. A 100-year bond, on the other hand, veers the widest from the U.S. Treasury’s “regular and predictable” issuance policy. It also greatly exceeds the duration needed by most private buyers and thus could be subject to unpredictable demand and price fluctuations.
  • Know that life insurers in particular have an incentive to go ultra-long. With liabilities reaching 40 or 50 years into the future, insurers and pension funds are in a bind: They can’t buy a safe, fixed-yield asset to defray the liabilities. This mismatch is why many firms are trapped in a perverse cycle of buying more shorter-term bonds as their yields fall (and their prices rise) to sustain yields in out years. The problem is particularly acute in Europe, where insurance companies make up 40 percent of the region’s total sovereign long bond pur­chases—and need to purchase more even when the yields go sub-zero. (The share of U.S. Treasuries held by U.S. insurers is much lower, around 12 percent.)
  • Don’t expect state-run pensions to make a run at ultra-long bonds. Like life insurers and company pensions, state-run pensions have long-term liabilities that should be matched with long-term assets. But most state-run plans face such massive shortfalls that no such matching is possible—at any conceivable yield. Every single state pension is underfunded by at least $19,000 per household, and many of the nation’s worst-off plans face the prospect of either gutting payouts or going insolvent. In fact, many pension plans are moving to ever-riskier and shorter-term asset classes (like stocks) in an attempt to make up ground. (See: “America’s Pension Battle Heats Up.”)